Roth IRA distribution rules at risk

Millions of U.S. investors are smitten with the Roth IRA.
Contributions to the retirement vehicle topped $500 billion by the
end of 2013, according to a report by the Investment Company Institute, a
mutual-fund trade organization.

But President Barack Obama’s 2015 budget includes a pair of
proposals that threaten to take away some of the Roth’s most
alluring features. Both involve changes to Roth IRA distribution
rules.

The first change would compel all people with Roth IRAs to take
required minimum distributions, or RMDs, beginning at age 70
1/2.

In addition, the president’s budget would require nonspousal IRA
beneficiaries to disburse inherited IRAs within five years of the
owner’s death. This would prevent these beneficiaries from
“stretching” distributions over their expected lifetime to minimize
tax consequences.

Changes would help Treasury pay bills

The proposed changes clearly are intended to raise revenue for a
nation awash in red ink, says Michael Rubin, CFP professional and
founder of Total Candor, a financial planning education firm based
in Portsmouth, New Hampshire.

“We have a government with a significant amount of debt that has
to be paid back,” he says.

But the new rules could have a negative impact on many investors
who have Roth IRAs, says PJ Wallin, CFP professional and founder of
Atlas Financial in Richmond, Virginia.

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“It’s unfortunate,” he says, adding that the moves primarily
impact “those who have diligently saved throughout their
lifetime.”

Change No. 1: Mandatory minimum distributions

Not everyone agrees that such changes would have a significant
impact on investors.

The rule to impose RMDs simply would bring Roth IRAs into line
with traditional IRAs, which already require mandatory
distributions at age 70 1/2, says Andrew Novick, CFP professional
with The Investment Connection in Center Valley, Pennsylvania.

He also notes that under the new rules, all qualified
distributions would remain tax-free.

“I don’t think it would change people’s perceptions of Roth IRAs
much,” he says. “They will still view them as excellent tax-free
growth vehicles.”

However, Wallin says requiring mandatory minimum withdrawals
likely would hurt Roth IRA owners who plan to pass their assets on
to loved ones.

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Beneficiaries would benefit less

Because the new rule would compel Roth IRA owners to take
withdrawals during their lifetimes, the money would have less time
to compound tax-free before it is bequeathed to the
beneficiary.

For example, a Roth IRA owner who lives to age 90 would face
nearly two decades of required withdrawals. Money withdrawn from
the Roth during that time no longer could grow tax-free.

That fact could result in a “substantially different
inheritance” for beneficiaries, Wallin says.

Eric Roberge, CFP professional and founder of Beyond Your
Hammock, agrees: “This will have a dramatic impact on those who
have a good amount of money in retirement accounts.”

Forcing Roth account owners to take RMDs at age 70 1/2 “will
deplete this extra money” that account holders planned to pass to
heirs, he adds.

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Change No. 2: Quick disbursement for some beneficiaries

The second proposed change would require certain beneficiaries
to disburse funds within five years of the owner’s death.

The new rule would target so-called “stretch” IRAs. Currently,
nonspousal beneficiaries of Roth IRAs must begin taking required
minimum distributions after the Roth IRA account owner’s death.
However, beneficiaries can mitigate the tax consequences by
“stretching” the distributions over an entire lifetime.

The new rule would change that by making nonspousal
beneficiaries liquidate the accounts within five years.

“Accelerating distributions of inherited IRAs will result in
more taxable income now, which the government wants,” Novick
says.

Novick believes this second change would have a more significant
impact than the first change.

Changes would constrain conversions

“This is a much bigger deal,” Novick says. “It makes inherited
IRAs a lot less appealing.”

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If the new rule is approved, it is likely to result in one
immediate change, Novick says.

“Older account holders will be less inclined to convert a
traditional IRA to a Roth,” he says.

“There won’t be enough years of tax-free growth to warrant
paying tax now on the conversion.”

Conversions have become increasingly popular, especially among
high-income earners. In 2010, conversions to Roth IRAs topped $64.8
billion, beating regular Roth IRA contributions for the first time,
according to a recent report from the IRS. That year, new tax
provisions opened Roth conversions to people of all income levels
for the first time.

How should you prepare?

Keep in mind that the proposed changes to the Roth IRA
distribution rules have not been approved.

After Obama unveiled his $3.9 trillion 2015 budget last spring,
the House of Representatives rejected the budget by a vote of
413-2. Critics denounced the vote as a political stunt.

Given the dysfunction in Washington, it’s not likely that a
budget — and the Roth IRA proposals within it — will be approved
anytime soon.

Novick says he is not recommending major overhauls to his
clients’ retirement strategies based on the potential changes.
However, he is taking a second look at some strategies.

“I will be more cautious about recommending Roth conversions,
especially to older clients,” he says.

Wallin is taking a wait-and-see approach to the proposed
changes. He says that in the past, many similar proposals have
ended up “going nowhere.”

“That said, never say never,” he adds.

Continue to diversify

Even if the Obama administration does not succeed in changing
Roth IRA rules at this time, Roth investors now have been put on
notice for possible future changes, Rubin says.

“I firmly believe that there will be an attack on the sacred
nature of the Roth IRA,” he says.

Rubin urges investors to prepare for such a possibility by not
putting too many eggs in the Roth IRA basket.

“You should be tax-diversified,” he says. “The most important
thing in investing is diversification, and it’s the same thing
here.”